UNIVERSITY OF THE WITWATERSRAND SCHOOL OF CIVIL AND ENVIRONMENTAL ENGINEERING CIVN2007: ECONOMICS AND MANAGEMENT COURSE NOTES: WEEK

1 Introduction Economics is the study of resources and how we can use and exchange these to give us the maximum benefit. It assumes that we have limited resources, but unlimited needs and wants. We use monetary value as a way of comparing and attaching value to a disparate variety of goods and services. It is important for civil engineers to have a broad understanding of economics, as we provide for needs and wants more efficiently than other people in society can, which means that fewer of these scarce resources are used up. Economics helps us to make sensible decisions, especially with regard to what projects to undertake: which ones will give us more value than it costs to construct them, and where we have a choice between projects, which will give us the maximum benefit. Sometimes the choice of one project will mean that another project cannot happen, because of budget or other constraints, so we have to be able to substantiate our decisions. This is especially important for public sector projects, where we are using public money and are therefore subject to public scrutiny. The Project Management part of the course gives us knowledge and techniques to help us carry out these economic decisions effectively, to achieve the objectives of scope and quality within the planned timeframes and budget. The course starts with some basic economic concepts and principles that will form some of the building blocks for their engineering applications. We will be focusing on project appraisal in the first part, with particular emphasis on municipal infrastructure. Demand The definition of demand is: The quantity of a commodity or service that you would be willing to buy, at a specific price. This comes from the observation that we will tend to buy a larger quantity of something if it is cheap, but less of it if it is more expensive. This is particularly clear with highly desirable luxury goods. For any one commodity or service, we each can plot a demand curve that shows this inverse relationship between demand and price. The diagram shows the simplest form of this relationship, in which there is a consistent relationship between price and quantity at all values:

Drivers of demand Preferences: These are shaped by advertising, health trends, cultural practices, ethics. Income: Low income earners will have less to spend on luxuries, so will probably have to save for them, however low the price; high income earners will tend to buy more of an item if the price goes down, up to a limit. Number and price of substitutes: You like Coke, but you think Pepsi is a reasonable substitute so if the price of Pepsi is lower than Coke, you will buy Pepsi. Substitutes depend on the individual some people will drink anything, whatever is cheapest; some are very fussy or loyal to a brand so will have fewer substitutes and the price would have to be very high to switch to something different; the entire market reflects the aggregate of these individual decisions. What else you need to spend your money on and what is more important: This relates to the price of your whole shopping basket, so if the price of one item that you need goes up, you have less money left for other less important things. Complementary goods: Some things have no value by themselves, so if the price of bolts goes up, you will buy less bolts AND nuts, even if the price of nuts stays the same.

Opportunity Cost Choices always involve sacrifices: If we had infinite money, we would not have to choose, just by anything and everything that took our fancy. When we exercise our choice, we are giving up all the other things that we have not chosen (at least for the time being). Definition of opportunity cost: the cost of the next best alternative foregone The sacrifices are your opportunity costs. Rational choices involve weighing up the benefit of an activity against the opportunity cost, so the difference in cost between the chosen item and the next best choice is a measure of how much we value the chosen one over the next best. You need to look at ALL the costs associated with the chosen item (or course of action) as well as ALL the costs of the next best alternative. (See the example in the PowerPoint.) Production Possibility Curve If we take this concept to the scale of a whole country, we can see how opportunity cost can apply to a country that wants to maximise its resources. In simplified form, we can consider a country that devotes all its resources to making clothing and growing food. At the extremes, it can produce only clothing and no food, or only grow food and make no clothing. It can also make combinations of the two products. The graph shows that at each end of the curve, the

total output diminishes (the curve tends to zero additional output, and can even tip below, showing that it is counterproductive to make even more units of the one product). The graph bulges outward (convex), because of the concept of increasing opportunity costs some land is arable, so it is wasted on factories; some people are good farmers and others better at making clothing. If we move along the curve from a to b (making more clothing) we have to make less food: we are giving up y units of food in exchange for x more units of clothing. If the country is producing below the curve (say at c), they are not using their resources to the full, eg there may be unemployment (idle labour) or land under-utilised. The country cannot produce above the curve (at d) because it does not have the resources at present. (This is where we come in as engineers to help the resources to be used to the full, then to improve the productive possibility of land, labour and capital, but more about this later) Theories of Value and Utility Utility is an important concept in Economics, defined as the usefulness, happiness or benefit that you get from a commodity or service. It is measured in utils, a somewhat artificial concept that allows us to compare the value that we attach to a quantity of benefit that we get from one commodity to that of another. The rational consumer will try to maximise utility from the goods and services acquired and consumed, ie you will get the best balance of goods and services within your means. This implies that the rational consumer will make the most beneficial choices in terms of each of our personal preferences. The two ways in which economists analyse our choices in terms of utility are: Marginal Utility Theory Indifference Analysis

Marginal Utility Theory The concept marginal is very important in economics. It refers to one more of the smallest unit of the thing being considered, so marginal utility is the satisfaction or benefit that you get from one more unit within a defined timeframe. When utility is measured in monetary terms, the marginal utility will be the amount that you are prepared to pay for one more unit. The graph shows that as you consume goods within the timeframe, your marginal utility diminishes, so you are prepared to pay less and less for each additional unit because it will give you less satisfaction.

The total utility curve (TU) shows that we hugely enjoy the first slice of pizza, but each successive one gives us less satisfaction (we are getting full) until half-way through the 4th slice, when we start to feel bad The marginal utility (MU) curve starts after the first unit (slice) and has a negative slope. If a util for myself equates to R1, and pizza slices are sold for R4, I would buy the first and the second slice, but not the third slice. (Note that it is not the cumulative cost and utility, but the cost and the utility of each next slice that matters.) If the pizza hut lowers the price to R2, I would buy a third slice. If the price goes up to R5, I would only buy one slice, as the second slice now costs R1 more than my marginal utility for slice number two. Consumer Surplus This is the excess of what you would pay over what you are actually required to pay. So the marginal consumer surplus is the price you are prepared to pay for one more unit of the commodity and what you are actually charged for it: Marginal Consumer Surplus (MCS) = Marginal Utility (MU) Price (P) In our example above, when the pizza costs R4, my consumer surplus for the first slice is R3 and zero for the second slice. At R2 per slice, slice one has a MCS of R5, slice two has a MCS of R2 and slice threes MCS is zero. Optimal Combination of Goods Because we all have a limited income, as rational consumers we need to maximize our total utility from all the goods and services that we buy. If the price of commodity x falls, you will buy more of this commodity and less of another commodity y to maximise your total utility. This is expressed as:

Indifference Analysis This is a somewhat more complex way of analysing our choices in that it ranks the combinations of goods according to our preferences. The indifference curve shows all the combinations of goods that give equal satisfaction (TU) to a consumer.

At income I1, if x is rice and y is chicken, you will be unwilling to give up some chicken to get more rice. As we move to the right of the curve, if we get much more rice, we will want more chicken as well! The curves I2 and I3 represent higher total utility, generally associated with increased income or willingness to pay more for the two goods. Note that the curves are not exactly parallel at higher income or expenditure we will be able to buy more of the costly good, reflecting a higher expectation of our total utility. This has a parallel with the expenditure on infrastructure of low and high income countries that we studied in CIVN1000. The bow in the indifference curve (concavity) shows the difference in what we would give up of the one item to be able to have more of the other. This is called the marginal rate of substitution: Marginal Rate of Substitution is the amount of one unit that we would sacrifice to have one more unit of the other. The Diminishing Marginal Rate of Substitution is the concept that the more you consume of x (rice) and the less you consume of y (chicken), the less additional y (chicken) you will give up for more x (rice). Optimal Level of Consumption We can introduce a budget line that shows all the possible combinations of goods x and y for the amount of money we are willing to pay. This line will be tangential to one of the curves on the indifference map (graph above), I1, I2, I3, etc. The optimal consumption is where the budget line touches the indifference curve this shows the combination of the two goods that give us maximum value for money in terms of our own preferences. It can be related to the cost of the two goods: Px/Py = MUx/MUy

If we buy a combination of the two goods that lie on an indifference curve closer to the origin, we will be under-spending in terms of our budget. If we are spending with a combination on a higher indifference curve, we will be exceeding our budget. This is important to understand when we look at project appraisal and budgeting for multiple projects, eg various levels of water supply in combination with different specifications for sewerage systems: we want the best combination that is closest to the budget.